Market Update

The S&P 500 gained 1.51% last week to finish at 3639.66. The index fell 4% from its Tuesday peak, finishing near its weekly low. The two-day bear market rally saw a gain of 6.2%. The rally fizzled out when it couldn’t break through the 20-day moving average. The S&P failed at the 20-day on both Tuesday and Wednesday. Renewed fear of the Federal Reserve was blamed for the rally ending. It is more likely that technical trading by the algorithms was responsible. It is the nature of bear market rallies that they flame out quickly and are technical in nature. The machines rule trading over the short term. The Nasdaq managed to hold on to a 0.73% gain for the week.

The S&P 500 is sitting on its 200-week moving average. It is important support. The index has tested the 200-week two weeks in a row. Another bear market bounce is likely if the 200-week holds for the next few weeks. The June and late September lows are also nearby support and would add to the significance of a break below. It would likely signal another down leg in the bear market.

Earnings season starts this week. Norwood Economics is expecting earnings to disappoint, or at least guidance to disappoint. A disappointing earnings season would likely lead to a rough October for stocks. But perhaps not as bad as many fear. We wrote a few weeks ago that pessimism was hitting extreme levels. For instance, the VIX finished above 30 again last week after hitting 35 on September 28th. A spike above 40 would likely signal an intermediate bottom at least.

The lower boundary of the trading channel is 3300. It's a reasonable downside target if support fails at the 200-week moving average. A decline to 3300 is another 9%. The total decline for the bear market would be almost 32%. Major support rests at 3,000, which would be a total decline of 38%. A decline of one-third is typical for a bear market accompanied by a mild recession.

Economic Indicators

The Atlanta Fed GDPNow forecast rose to 2.9% for Q3 up from 2.7% a few days prior. The GDPNow forecast is reasonably accurate within 30 days of the GDP report. A strong GDP print will confirm the consensus that the U.S. is not yet in a recession.

The economic data out last week also continues to show an expanding economy. The S&P U.S. manufacturing PMI final number was 52.0 for September. It was 51.8 in August. Any number over 50.0 indicates expansion. The ISM manufacturing number was 50.9% in September down from 52.8% in August. Motor vehicle sales rose to 13.5 million in September up from 13.1 million in August. Factory orders were flat in August, an improvement over the 1.0% decline in July. Core capital goods orders were revised up to 1.4% in August from 0.7%.

Job openings fell to 10.1 million in August from 11.2 million. The number of job openings is still well above average. The Quits number was 4.2 million in August up from 4.1 million. The Quits number is still signaling confidence among workers. People don’t quit their job unless they are confident they can find another. Initial jobless claims were a low 219,000. Non-farm payrolls rose 263,000 in September. Unemployment fell back to a 50-year low of 3.5%.

The inflation numbers come out Thursday. The median forecast of economists for the headline CPI is 8.1% down from 8.3%. The core number is expected to rise from 6.3% to 6.5%. Energy prices are moving higher once again. The headline number may surprise to the upside. The inflation numbers and the start of earnings season promise market volatility this week.

Market Timing, Stocks, and Intrinsic Value

Market timing is the strategy of buying and selling financial assets based on predictions of future market price movements. Market timing doesn’t work for most people most of the time. It doesn’t work for most people most of the time because we can’t predict interest rates very well. Interest rate forecasts are notoriously inaccurate. Market timing doesn’t work for most people most of the time as well because we can’t predict earnings very well. One study published in 2016 shows just how bad analysts are at forecasting earnings. Financial analysts over a 12-year period were “optimistically wrong with their 12-month earnings forecasts by 25.3% on average.” Interest rates and earnings are the two factors that most influence stock market movements. The inability to predict interest rates and earnings means an inability to predict market movements.

Investors can’t pick market tops or bottoms. Logically that also means they can’t pick stock tops or bottoms. Guessing which way a stock will go next month or next year is just as futile as guessing where the stock market will go. Nevertheless, it is possible to add value buying individual stocks. How do we reconcile those last two statements?

Stocks represent ownership in a business. The intrinsic value of a business doesn’t change just because its stock price changes. People forget that important fact. Apple stock rose from under $40 per share in late 2018 to $182.94 in early 2021. The stock price rose over 350% in less than three years. The value of Apple’s business did not increase by 350%. AAPL’s revenue rose by 38% from 2018 thru 2021. Its earnings rose by 59%. Earnings per share rose 88%. The price-to-earnings ratio rose from 13 to 31. Stock prices should always be viewed relative to the value of the underlying businesses. Apple’s investors forgot that simple concept as they paid more and more for each dollar of earnings.

Price is the most important determinant of returns. Buy a company for less than its intrinsic value. Sell a company when it is overvalued. You will outperform the market over the long run. You won't know the timing of that outperformance. We can't predict stock prices from year to year after all. Yet the outperformance will occur over the long run.

Norwood Economics bought seven oil stocks in 2020. They were trading for less than 50% of what the companies were worth. We still own two of them. Norwood Economics didn’t know how long it would take for those seven stocks to outperform the market. It was almost a certainty that they would though. And they have.

The five stocks we sold will likely move higher based on pure momentum. Investors like to buy stocks that are going higher. We don’t know where their tops will be for this business cycle. We only know the stocks are no longer trading below the value of the underlying businesses. We’ve also sold three drug companies this year, and for the same reasons.

Value investors pay attention to price. Value investors buy businesses when their stocks are trading well below what the businesses are worth today. Value investors seek a margin of safety. Buying stocks that are trading well below what the underlying company is worth is not market timing. Selling a stock when it is no longer trading at a discount to its business value is not market timing. Waiting for a stock to fall to a level that provides a margin of safety when purchased is not market timing. It is investing in good businesses when they go on sale. It is selling them for a profit when they are no longer on sale. Basic investing in other words.

Regards,

Christopher R Norwood, CFA

Chief Market Strategist